What Rising Inflation Expectations Could Mean For Bonds (TIP)

From BlackRock: A synchronized rise in global inflation expectations is fueling higher bond yields, and we see actual inflation running hotter in the U.S. than in Europe and Japan. Richard Turnill explains the implications for our views on inflation-linked bonds.

A synchronized rise in inflation expectations, reflected in rising bond yields, shows markets are growing more confident that global inflation has finally hit bottom. But we see actual inflation running hotter in the U.S. than in Europe and Japan, and this is shaping our views on inflation-linked bonds.

The main driver behind the recent move higher in U.S. 10-year yields has been a rising U.S. 10-year inflation breakeven rate, which now implies average headline inflation above 2% over the next decade. Breakeven rates–the difference in yields between nominal and inflation-linked bonds of the same maturity–reflect market expectations for inflation. Breakeven measures in the eurozone and Japan have also improved meaningfully lately, but from subdued bases. See the chart below.

We see these market moves as a renewed sign of confidence that price pressures are building. The strengthening global economy and expectations of U.S. fiscal stimulus appear to be heralding a turnaround in market sentiment after fears of near-zero headline inflation two years ago. Rising energy prices are also helping fuel conviction that inflation may be at a turning point globally.

Yet we see diverging trends in actual inflation across regions. Breakeven rates track headline Consumer Price Index readings, which include the volatile food and energy prices that core measurements exclude. Our BlackRock Inflation GPSshows U.S. core inflation rising close to the Federal Reserve’s (Fed’s) 2% target in 2018. U.S. wages are grinding higher and one-off factors are set to wash out of U.S. inflation readings, part of the Inflation comeback theme in our 2018 Global Investment Outlook.

In contrast, our GPS points to inflation in the eurozone and Japan bottoming out but stuck well below central bank targets. Core inflation in both those economies is tepid, and ample spare capacity means price pressures are limited. We agree with the view of the European Central Bank (ECB) that eurozone core inflation may be stuck below target through 2019. We see inflation in Japan inching up but still being very subdued. This is why we expect both the ECB and Bank of Japan (BoJ) to keep policy loose, whereas the Fed looks poised to deliver at least three rate increases in 2018. One outlier: the UK, where we believe inflation has probably peaked and will gradually glide lower as the British pound recovers from its selloff following the Brexit vote.

U.S. fiscal support at this stage of the economic cycle could raise concerns of U.S. overheating, as we write in our latest Fixed income strategy piece. We believe the Fed would likely delay any pre-emptive action such as more or larger rate increases. But an inflation acceleration could ultimately result in an increasing inflation risk premium. Against this backdrop, we prefer inflation-protected securities over nominal bonds in the U.S., particularly at the long end of the curve. Valuations on U.S. Treasury Inflation-Protected Securities (TIPS) look more attractive than those of developed-market counterparts and are poised to benefit from an actual inflation comeback, in our view. Reigniting inflation expectations could also help halt the recent curve-flattening trend in nominal bonds, we believe. Read more market insights in my Weekly Commentary.